Title: Does Faster Loan Growth Lead to Higher Loan Losses
Abstract: During the last couple of years, concern has increased that the exceptionally rapid growth in business loans at commercial banks has been due in large part to excessively easy credit standards. Some analysts argue that competition for loan customers has greatly increased, causing banks to reduce loan rates and ease credit standards to obtain new business. Others argue that as the economic expansion has continued and memories of past loan losses have faded, banks have become more willing to take risks. Whichever explanation is correct, the acceleration in loan growth could lead eventually to a surge in loan losses, reducing bank profits and sparking a new round of bank failures. As the experience of the early 1990s made clear, such a slump in banking could not only threaten the deposit insurance fund but also slow the economy by discouraging banks from granting new loans. The view that faster loan growth leads to higher loan losses should not be dismissed lightly; nor should it be accepted without question. If loan growth increases because banks become more willing to lend, credit standards should fall and loan losses should eventually rise. But loan growth can increase for reasons other than a shift in supply-for example, businesses may decide to shift their financing from the capital markets to banks, or an increase in productivity may boost the returns to investment. In such cases, faster loan growth need not lead to higher loan losses. This article explains why supply shifts are necessary for faster loan growth to lead to higher loan losses and determines if supply shifts have caused loan growth and loan losses to be positively related in the past. On balance, the article finds limited support for the view that supply shifts have caused loan growth and loan losses to be positively related. Data on business loans and delinquencies show that states experiencing unusually rapid loan growth tended to experience unusually big increases in delinquency rates several years later. This finding is tempered, however, by evidence on business loan growth and business credit standards suggesting that changes in loan growth are not always due to shifts in supply. The first section of the article explains how loan growth and loan losses might be related. The second section examines the relationship between business loan growth and business credit standards, drawing on the Federal Reserve's Senior Loan Officer Survey for the periods 1967-83 and 1990-98. The third section investigates the relationship between business loan growth and business loan delinquencies, using statewide data for the period 1982-96. POSSIBLE RELATIONSHIP BETWEEN LOAN GROWTH AND LOAN LOSSES An obvious reason loan growth and loan losses might be related is the business cycle. Loan growth tends to be high during business expansions, while loan losses tend to be high during business contractions. Thus, as a result of the business cycle, periods of rapid loan growth naturally tend to precede periods of high loan losses. But does faster loan growth lead to higher loan losses even after controlling for the state of the economy? Using a simple model of the market for bank loans, this section identifies when such a relationship between loan growth and loan losses is likely to exist. The section then suggests how data on loan growth, credit standards, and loan losses can be used to test the view that faster loan growth leads to higher loan losses. Why faster loan growth might lead to higher loan losses Most of the reasons usually given for faster loan growth leading to higher loan losses involve supply shifts-that is, increases in banks' willingness to lend. When such a shift occurs, banks typically seek to increase their lending in two ways. First, they reduce the interest rate charged on new loans. Second, they lower their minimum credit standards for new loans-for example, they reduce the amount of collateral the borrower must have to back his loan, accept borrowers with weaker credit histories, or require less proof that the borrower will have enough cash flow to service his debts. …
Publication Year: 1999
Publication Date: 1999-03-22
Language: en
Type: article
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Cited By Count: 165
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